Big banks become a better bet

Mitchell Starc celebrates during game one of the Commonwealth Bank One Day International against Sri Lanka in Melbourne on Jan. 11; investors in the bank had reason to rejoice on Jan 29 when its shares hit a record high.
AFR

As 2013 gets under way with
Commonwealth Bank of Australia
shares hitting a record high of $65.10, there is one burning question in the minds of many retail and institutional investors: should I throw another roll of the dice on the big ­Australian banks?

Chanticleer reckons the answer is yes. The arguments in favour of that point of view can also be used to defend a shift into non-financial equities by those sitting on cash.

Buying three of the big four banks and the regional bancassurance group,
Suncorp
, was one of the best trades of 2012. The blanket approach did not work because of the poor sharemarket performance of
National Australia Bank
,
Bank of Queensland
and
Bendigo and Adelaide Bank
.

But those who picked
ANZ Banking Group
, CBA and
Westpac Banking Corp
on January 1 last year ended the year with very strong capital gains and enjoyed a juicy dividend yield in excess of 6 per cent.

It was the dividend yield that redeemed those who picked NAB, BoQ and Bendigo. But the relative performance of these stocks was ordinary compared with CBA and Westpac, which delivered total returns (including dividends) of more than 28 per cent. ANZ returned about 22 per cent and Suncorp delivered a return of more than 26 per cent.

It is clear from this year’s market movements that there are plenty of investors willing to have another throw of the dice on the big banks. Chanticleer believes there are good reasons why this “gamble" stacks up.

First, the world is a much better place than it was 12 months ago. There are green shoots of economic revival in the US, Europe looks as though it will hold together even if it is with paper and string, and China is growing at levels that support Australia’s mining sector.

Second, the dividend yields that underpinned market valuations in 2012 are still in place. Dividend yields of 5.5 to 6 per cent are attractive when term deposit rates are falling.

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Also, bank dividends carry franking credits that elevate the overall return depending on the shareholder’s tax position. Bank dividends are growing at about 5 per cent a year, which is in excess of inflation.

Third, the managements of banks are maintaining tight cost control disciplines. A bank that can keep cost growth at 2 or 3 per cent will deliver higher profits even in a low credit growth environment.

There is an upside to low credit growth. It means banks require less capital to back new loans. This means cash generated from the existing book can be directed to shareholders rather than capital reserves.

Another way of looking at the positive case for investment in banks is to go through the arguments against them. The most obvious one is that while the Australian economy is growing it is consumed by negative sentiment that is affecting many businesses. Much of this negativity is driven by corporate cost cutting that is making people uncertain about their jobs.

That line of argument says that an environment in which the Reserve Bank of Australia is cutting interest rates is also a world in which unemployment will rise and therefore cause bad debts to rise. This in turn would cause banks to have higher provisions for bad debts that would lower profits.

But investing is as much about the weight of money as it is about the facts. Lower interest rates will unleash a wave of liquidity from ­people unhappy with the decline in term deposit rates and seeking to protect their level of income.

However, the most important point is that unemployment needs to rise substantially before it would have a big impact on the bad and doubtful debts generated by people not paying their mortgages. Unemployment is 5.4 per cent and may head higher, but it is difficult to see it reaching levels that would cause a spike in bad debts.

Banks report that most mortgage borrowers are repaying their loans at rates that are well in excess of the minimum required under their repayment schedules.

There is no doubt that households and businesses are caught up in a mood of caution. This was confirmed on Tuesday with the release of the NAB Monthly Business Survey. Conditions improved marginally in December.

The other factor that is cited as a reason to steer clear of Australian banks is the high leverage involved.

A fund manager at Platinum Asset Management, Jacob Mitchell, highlighted this in a note to clients earlier this month. He said investors should consider the sustainability and growth profile of popular yield stocks such as the big banks.

He says the local banking sector has a tangible capital base that is leveraged roughly 21 times compared with 15 times for a United States bank such as Bank of America.

Also, he highlights the fact that the loan books of Australian banks are concentrated in residential mortgages. About 60 per cent of assets are in mortgages and the risk-weighting model used for capital means the treatment of mortgages here is much more lenient than in other countries.

Typical risk weights for Australian mortgages are 20 per cent compared with 35 to 75 per cent in the US and just under 35 per cent in Japan.

He says most socio-economic systems have a tendency to develop their own “expedient bias". “If investors deem the yield on Australian bank shares to be attractive, they should also be aware of how leveraged to the Australian property cycle that yield really is," he says.

Chanticleer agrees that every great trade must come to an end. But it is hard to see a property bubble existing in Australia, or the catalyst for that so-called bubble to burst.

For the record, at Tuesday’s close of $64.73, CBA is one of the most expensive bank shares in the world. It is priced at 2.5 times its book value and trades on a price earnings multiple for 2013 of 14.5 compared with market price-earnings ratio of 13.5.

However, only one broker says buy the bank at these prices. Most analysts are either neutral, or say sell. But Chanticleer suspects this will change if the price continues to rise.

The case for bank stocks can easily be used in the case for other high-yielding stocks, such as Telstra. But there are dangers in stretching the strategy to high-yielding cyclical stocks in the retail sector. They are high yielding but the challenges they face from a high dollar and changing patterns of consumer behaviour could make them a value trap.

One final point about bank stocks. They tend to rally leading up to financial results as investors lock in positions before dividends are declared. The stocks then fall afterwards as the dividend strippers move on.

Macquarie Group
’s run-in with the corporate regulator over slack compliance with long-standing rules for financial advisers opens a window onto the culture inside one of the four divisions of one of Australia’s most successful financial institutions.

The view inside is not flattering. In fact, it is somewhat worrying. The Australian Securities and Investments Commission has uncovered a lackadaisical attitude to compliance and a stubbornly arrogant resistance to change once found out.

It is hard not to get the impression that financial advisers working in Macquarie Private Wealth were too busy trying to sell stocks and had ­little time to document the advice they were giving.

Outsiders rarely get to look inside the secretive Macquarie edifice, which is why the ASIC enforceable undertaking released on Tuesday is revealing.

It would appear that behind the group’s high castle walls, there has been a flagrant disregard for compliance with important obligations imposed by the Corporations Act.

One of the big accounting firms will win the lucrative gig to help Peter Maher, who is head of banking and financial services, get on top of the problems and keep ASIC informed about remedial action.

But that still leaves a big unknown. Is the culture in private wealth repeated in other parts of the group?

The company desperately needed to slash its debt to put its balance sheet on a viable footing. Westpac allowed Oldfields to buy back $8 million in bank debt for $2.5 million, following a $2.6 million capital raising.

The company was able to cut its interest bearing debt to $4.2 million. Westpac’s interest payments on a deferred loan note will rise in tandem with the Oldfields share price over and above the rights issue price of 10¢ a share, but capped at 12.5 per cent.